Renting out Primary residence - tax implications

[Corey M.]

As noted in another post, I'm considering renting out my LA condo, which will be cash flow negative in the range of $500/mo. I bought the house for $320k with 20% down, did a cash out refi recently and got a new $420k loan. That means there's about $230k in equity left in the home. 

If I rent it out, it'll be at around $3k/mo, but with all expenses, it'll cost me $500/mo, so I'll be losing $6k year in cash. Assuming the property conservatively appreciates by 3%/yr, does this move make sense over a turnkey (not that I only want a passive investment) with an ROI of about 17% (including cash flow, appreciation, and house paydown)?

My understanding is that I can no longer get the $250k cap gains exclusion if I move out and don't live in the place in three years. But what if I want to keep this as a long term rental property and sell it in a decade? Am I out of luck and have to pay taxes on what would've been a $250k exclusion? To me, renting out the primary residence only makes sense if I can do it for the long term, especially when housing prices could drop 10-20%+ in one year (like they did around 2007 in LA). 

Assuming I can afford to lose $6k/yr on the negative cash flow, is turning this into a longterm rental going to be a bad decision if I don't plan on selling it within three years? Is there any way to hold onto that $250k exclusion if it's a long term rental? 

[Tony Kim]

Originally posted by @Corey M.:

As noted in another post, I'm considering renting out my LA condo, which will be cash flow negative in the range of $500/mo. I bought the house for $320k with 20% down, did a cash out refi recently and got a new $420k loan. That means there's about $230k in equity left in the home. 

If I rent it out, it'll be at around $3k/mo, but with all expenses, it'll cost me $500/mo, so I'll be losing $6k year in cash. Assuming the property conservatively appreciates by 3%/yr, does this move make sense over a turnkey (not that I only want a passive investment) with an ROI of about 17% (including cash flow, appreciation, and house paydown)?

My understanding is that I can no longer get the $250k cap gains exclusion if I move out and don't live in the place in three years. But what if I want to keep this as a long term rental property and sell it in a decade? Am I out of luck and have to pay taxes on what would've been a $250k exclusion? To me, renting out the primary residence only makes sense if I can do it for the long term, especially when housing prices could drop 10-20%+ in one year (like they did around 2007 in LA). 

Assuming I can afford to lose $6k/yr on the negative cash flow, is turning this into a longterm rental going to be a bad decision if I don't plan on selling it within three years? Is there any way to hold onto that $250k exclusion if it's a long term rental? 

I think this is a bad decision, but not because you'd be a relinquishing the section 121 deduction. I'd recommend against it because you are projected to have a negative cash flow. I know that part of this is offset with principal mortgage pay down, but it just does not make sense to convert this to a rental while absorbing neg cash flow.

With that said, since your original question was asked under the assumption that you would be fine with absorbing the monthly neg cash-flow, I think a reasonable alternative might be to convert it to a rental for a few years and see how it goes. After a few years you can make the decision whether or not you want to sell.

I also converted my LA condo into a rental several years ago. When the 3-year point was approaching, we took a hard look at our options and decided to keep it as a rental. In hindsight, it was one of the best decisions I ever made. But, the property also had significant positive cash flow....so we didn't mind holding on to it indefinitely. We exchanged that condo for a multi-unit in South LA a few years ago.